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PTPs Can Use Safe Harbor to Determine COD Income That Is “Qualifying Income”

In Rev.
Proc. 2012-28, the IRS issued a safe harbor for publicly traded
partnerships (PTPs) that want to avoid corporate taxation by
qualifying under Sec. 7704(c) as partnerships with 90% or more
of their income from qualifying sources. Under the safe harbor,
the IRS will not challenge a PTP’s determination that
cancellation of debt (COD) income is qualifying income if it is
attributable to debt incurred in direct connection with the
PTP’s activities that generate qualifying income (qualifying
activities).

According to the IRS, the purpose of the
exception under Sec. 7704(c) is to except from corporate-level
taxation those entities that are engaged in activities that are
commonly considered to be investment activities or that
traditionally have been conducted in partnership form.

The revenue procedure permits the PTP to use any reasonable
method to demonstrate that COD income is attributable to debt
incurred in direct connection with the PTP’s qualifying
activities. It also states that one reasonable method is to
trace the proceeds of the debt generating COD income to
qualifying activities under an approach similar to the one used
in Temp. Regs. Sec. 1.163-8T. In addition, the revenue procedure
specifically notes that the IRS will not consider reasonable a
method that allocates COD income based solely on the ratio of
qualifying gross income to total gross income. However, the IRS
may consider issuing letter rulings on whether a particular
method is reasonable.

The revenue procedure is effective
for COD income attributable to debt discharged on or after June
15, 2012, but it may be applied by PTPs for any tax year for
which the statute of limitation is still open (generally three
years from filing/two years from payment).

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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